Fund strategies: Distressed

Heading into 2016, investors of all stripes were concerned about negative market conditions in the US, including falling stocks, high-yield bond travails, tumbling oil prices and various other clouds hanging over the market. But midway through the first quarter, conditions took a turn. Some of these indices started rising and other economic indicators showed better results. 

While many private debt managers were beating the drum for distressed investing at the beginning of the year, they are no longer sure the distressed wave is coming soon. Between the interviews being conducted for this article in mid-June and PDI being published in July the picture could yet look a lot different. 

So where does this flip-flopping market leave the large pools of capital that have been raised for distressed and special situations investing? According to PDI Research & Analytics, 19 funds raised $23.4 billion last year and there are multiple distressed and special situations funds currently in the market seeking a combined $96 billion. One trend emerging among debt managers is the tendency to offer funds or separate accounts that can tactically allocate between regions and different types of credit as opportunities arise. 

“A lot of capital has been raised by the mega brand-name funds. These funds tend to have longer investment periods and have made the pitch to their investors that a distressed cycle is coming, though no one has a crystal ball, so it’s best be to be invested early with a fund with a longer and more flexible investment mandate,” says Ben Schryber, global head of credit at placement agent First Avenue Partners.

 

THE GLOBAL APPROACH

One firm that recently closed a large special situations fund is investing the money globally. When KKR closed its special situations fund on $3.4 billion in April, special situations co-head Jamie Weinstein was telling PDI that distressed opportunities looked more interesting in the US compared with mid-2015. However, since then he says US distressed opportunities have again abated and KKR is doing more work in Europe and Asia, particularly India and China.

One of KKR’s recent deals involved a partnership with Greece’s Eurobank and Alpha Bank as part of the Pillarstone programme formed last year to partner with banks on non-performing loan workouts. The new partnership mirrors another partnership that KKR has worked on in Italy. “[The banks] contribute loans to the platform. We take over the management of those positions and workouts. We commit new money to those underlying companies to fix or improve their capital structure or liquidity and then we share the upside with the banks,” Weinstein says.

In India, new regulation could lead to more opportunities for foreign investors (see next feature). However, Weinstein cautions that between the passing of a new bankruptcy code and its implementation, many other pieces need to fall into place for it to become a healthy market. 

KKR has 15 people working on deals in Mumbai and Weinstein says it’s important to have people on the ground in India who know how to avoid the risks posed by an immature private loan market. In China, where KKR also has local presence, there is more talk of building an NPL securitisation market.“What’s notable about what’s going on in China is that there is a lot more chatter about loan pool sales and the development of a true NPL securitisation market,” Weinstein says. 

While they don’t play much in Asia debt, other US-based distressed managers have been launching so-called “global” funds. Both Oak Hill Advisors (OHA) and The Carlyle Group are raising $2 billion distressed funds that plan to tactically allocate between the US and Europe as opportunities arise. OHA previously managed separate US and European funds, while Carlyle’s Strategic Partners distressed fund series historically dedicated more money to the US.

FLEXIBLE MANDATES

Other firms are approaching credit by diversifying funds or separate account mandates both regionally and strategically, where they can dip in and out of liquid and illiquid credit, or performing vs non-performing loans.

“Many LPs are electing to go the SMA route rather than invest in funds. Managers with diverse capabilities across the credit spectrum are the most likely to offer SMAs and there are numerous benefits to both GPs and LPs,” says First Avenue’s Schryber.

Ares Management recently combined its tradable credit and direct lending groups into one $60 billion credit business, particularly to offer these types of mandates. The firm is increasingly getting inquiries from clients about large multi-strategy credit separate accounts. 

“Many of our large investors are saying, ‘I would like to write a single cheque that meets my goals in terms of returns and leverage,’” says Kipp deVeer, Ares’ co-head of credit. “So they give us an allocation of their portfolio looking for us to provide exposure to different types of credit on a one-stop-shop basis.”

These strategies span the gamut of performing and non-performing loans, asset-backed lending, structured asset investing, syndicated CLOs, directly originated loans, commercial assets and other types of debt.

Greg Margolies, Ares’ other co-head of credit, says the firm runs special situations funds that are long-dated and pursue “go anywhere” types of credit strategies. The firm’s NPL deals get done in the less-trodden mid-market, where he says there is less competition. “We’ve done a handful of smaller mid-market NPL deals, so we tend to fly under the radar there,” Margolies says.

LPs like large diversified mandates for their customisation aspects and potential for lower fees on larger ticket sizes. Investors have recently been cutting the number of alternatives managers, aiming to have fewer relationships with larger mandates, deVeer says. A firm like Ares that can take such large accounts and allocate the money across different strategies could benefit from this trend, of course, while smaller firms would be at a disadvantage.

Ivan Zinn, chief investment officer at Atalaya Capital Management, also points out that many LPs have been cutting back on hedge funds because of poor performance and adding to private credit managers, a trend Atalaya has benefitted from. The firm has been running a series of special opportunities funds since its founding in 2006. It invests in a variety of corporate liquid and illiquid credit, real estate and specialty finance.

Zinn tells PDI he has done fewer traditional corporate direct lending deals in recent years as the space has become overcrowded with new entrants and plenty of capital. Instead, he’s investing more money in specialty finance companies, real estate deals and other strategies. 

“Our investment pace has been moderately slower this year than last year on the opportunistic buying side of the business. But we think that’s really driven by public market volatility, causing the private markets to sit on their hands some,” says Zinn. 

One recent deal was actually a return to an unnamed company Atalaya was refinanced out of before. “We bought bonds in something we had been refinanced out of a few years ago, but the bonds were trading at a discount, they were senior secured and they looked like something we’d structurally do,” he says.

Meanwhile, TPG Special Situations Partners is raising its third pool of TSSP Adjacent Opportunities (TAO), which has an open-end fund structure and can invest money across TSSP’s various debt credit strategies and funds.

TAO funds, which have been running since 2009, are designed to go after specific opportunities quickly. Whether it’s European bank loans or energy, by the time a dedicated fund is raised, the firm might have missed the opportunity, but the TAO strategy lets TSSP pounce on these investments as they arise, people familiar with the firm say.

The average ticket size on a TAO investment is usually around $250 million. The whole TAO complex has about $7 billion in assets, including two prior funds, and can deploy capital from all three.

THE HAIRY ISSUE OF FEES

Most private debt managers only charge fees on invested capital, rather than on commitments. In distressed, or other strategies viewed as cyclical, it’s seen as the more investor-friendly approach.

However, critics say this could lead to firms piling into deals at the wrong time. “These longer lock funds almost always charge fees on invested capital, which keeps managers incentivised to be patient. My concern with these funds is that they might be too patient and find themselves having to deploy a significant amount of capital toward the end of the investment period irrespective of whether a true distressed cycle hits or not,” says First Avenue’s Schryber. There are also some new creative fee structures out there. For example, Oaktree Capital Management has its Fund X and Xb pools of capital, where one is a $3 billion fund that’s designed to put money to work right away, while the other is a “reserve pool” that will be switched on at a later date when more distressed opportunities come to market. Oaktree has already raised more than its $10 billion target for the funds, though the firm has continued gathering assets and building a war chest of dry powder for when distressed opportunities finally flood the market. 

Oaktree is waiving fees on the second pool of capital, though some competitors point out that by still charging fees on commitments on the first (or mandating that the money be put to work right away so it can earn fees), this structure might actually be more beneficial to Oaktree than LPs.

Centerbridge, which recently launched a $5 billion fundraising for its third distressed credit fund, is doing something similar. The fund involves a main fund and a “flex” account to be switched on at a later date. The capital will be allocated to the two sleeves at 25 percent and 75 percent, respectively. Investors have to sign up for both the main fund and the flex account. 

NOTHING TO DO

One debt manager who preferred to remain nameless and has a large pool of capital in distressed assets in both the US and Europe says there is simply nothing to do in either place. And no, it’s not Fortress Investment Group’s Peter Briger, who has been saying for several months (if not years) that distressed credit opportunities look muted or boring. 

Fortress has still been delivering strong returns in credit, though Briger has pointed out that the performance was made on investments from some time ago, and as the firm seeks to redeploy capital to newer opportunities, there aren’t as many good deals to be had. Fortress Credit Opportunities III reported 9.9 percent net IRR since inception through 31 March this year. The first fund in this series posted 23.8 percent net IRR. 

Managers’ approach to distressed investing in recent years has also led to a wide dispersion in returns. Oaktree, arguably the best-known distressed manager in the US, has been posting weak numbers on its latest US distressed funds, as the firm has kept investing while distressed opportunities in North America have been scarce. Fund IX lost 2.4 percent net through the first quarter this year, according to Oaktree’s earnings report, while Fund VIII gained just 4.1 percent since inception.

Oak Hill Advisors, on the other hand, spent the last couple of years harvesting the money in its latest US distressed fund, rather than investing new money. The OHA Strategic Credit Fund posted over 20 percent net IRR since inception.

Whatever approach managers take, there is no denying that it’s hard to time the distressed investment opportunity. And while the flexible or global approach may work for some, getting the timing right, making money on the GP side and being fair to investors on terms and fees will be all the more difficult to accomplish. 


THE VETERAN CONTRARIAN
While many alternative lending businesses were launched (or became popular) post crisis, one firm that has been investing in direct lending and special situations for close to 20 years actually decoupled the two in 2009. Michael Leitner, managing partner at Tennenbaum Capital Partners, says the firm recognised that keeping these strategies bolted together wasn’t a good idea for a number of reasons.
 
“In the aftermath of the credit crisis, there was a general awakening both by fund managers and LPs, that certain strategies are not practical in the same fund, given the fund-level leverage incurred in many multi-strat credit funds,” Leitner says.
“The first conflict is that it’s very difficult to operate a distressed strategy in a multi-strat fund that has leverage” as positions go through restructurings and turn into equity stakes and further equity investment is required.
The other issue involves fees. “The multi-strat funds charged a fee structure reflective of the higher cost strategy, which would be the special situations/distressed focus. If you have performing loans in there, why would an investor be paying a PE-level management and incentive fees on assets that are only generating an 8-9 percent return?”